What the Subprime Crisis Shows
The structural problems with the housing market stem from over-regulation. Zoning and anti-growth laws limit supply in the face of demand stemming in part from a 10% increase of population growth decade over decade. This is exacerbated by harmful regulations that have limited corporate productivity: Sarbanes-Oxley, software anti-trust, and a myriad of minor regulations. Consequently, the liquidity from monetary easing didn’t go into industrial/commercial loans where the return was limited but into housing where the price appreciation was largely the result of supply constraints.
The housing bubble was government caused. The innovations used to fund that coordinated speculative excess are secondary. It was the underlying fundamentals caused by government regulation that directed mal-investment into a consumer good, housing. Yes, there were unwise lending practices during the tail-end of the investment cycle and this happened before in the sub-prime industry six years ago. However, coordinated mal-investment and coordinated liquidation is a result of macro-policies in the face of regulations.
The demagogues will pile on, just as they did in the face of the accounting irregularities exposed by the stock-market fall six years ago. These rabble-rousers will layer on another level of regulations to compound the mal-investment correction. What this exposes is the increasing inability to whether economic challenges without panicking. This is extremely worrisome and portends a grave problem if there were a major economic challenge.
What could create such an economic challenge? A significant attack on New York, perhaps by a dirty bomb, could make a large area unusable. The economic pain (far worse that New Orleans) would be accompanied by a demand for government control that would compound the damage by an order of magnitude. Such a downward spiral would be catastrophic. In essence we are unprepared and ready-to-fail if and when such an emergency arises. A healthy culture maintains its discipline and responds rationally.
Update 8/07: Let Thomas Sowell explain it.